Understanding Irrevocable Trusts with Grantor Trust Provisions
Irrevocable trusts have long been a cornerstone of sophisticated estate planning in California and beyond. These trusts were often established for purposes such as:
- Gifting: To transfer wealth to heirs while minimizing estate and gift taxes.
- Medi-Cal Planning: To protect assets while qualifying for California Medi-Cal benefits.
- Asset Protection: To shield assets from potential creditors.
Many of these irrevocable trusts are structured as grantor trusts under Internal Revenue Code (IRC) Sections 671–679. In a grantor trust, the grantor retains certain powers or benefits, such as the ability to substitute assets or pay taxes on trust income. This structure allows the trust’s income to be taxed to the grantor, which can reduce the grantor’s estate while allowing the trust assets to grow tax-free for beneficiaries.
Historically, a key advantage of placing assets in an irrevocable grantor trust was the assumption that these assets would receive a step-up in basis upon the grantor’s death. A step-up in basis adjusts the tax basis of an asset to its fair market value at the time of the grantor’s death, reducing capital gains tax liability when beneficiaries sell the asset. For example, if a grantor placed stock valued at $100,000 into a trust and it appreciated to $500,000 by the time of their death, the basis would “step up” to $500,000, eliminating capital gains tax on the $400,000 appreciation if sold.
Revenue Ruling 2023-2
In 2023, the IRS issued Revenue Ruling 2023-2, which clarified that assets held in an irrevocable grantor trust not included in the grantor’s taxable estate will not receive a step-up in basis upon the grantor’s death. This ruling directly challenges the prior understanding and has significant tax implications for trust beneficiaries.
The reasoning behind Revenue Ruling 2023-2 hinges on IRC Section 1014, which governs the step-up in basis. Section 1014 generally provides a step-up in basis for assets included in a decedent’s gross estate for federal estate tax purposes. Since irrevocable grantor trusts are often designed to exclude assets from the grantor’s taxable estate (to reduce estate taxes or protect assets), these assets do not qualify for the step-up in basis under the new ruling. As a result, beneficiaries inheriting appreciated assets may face substantial capital gains taxes when selling those assets, based on the original basis rather than the fair market value at the grantor’s death.
For example, consider a grantor who placed real estate valued at $200,000 into an irrevocable grantor trust. By the time of their death, the property is worth $1,000,000. Under the pre-2023 assumption, the beneficiaries would receive a stepped-up basis of $1,000,000, avoiding capital gains tax on the $800,000 appreciation if sold. Post-Revenue Ruling 2023-2, the basis remains $200,000, potentially resulting in a capital gains tax liability on the $800,000 gain.
Implications for California Residents
For California residents, the impact of Revenue Ruling 2023-2 is particularly significant due to the state’s high property values and capital gains tax rates. California imposes a state income tax in addition to federal capital gains tax, with top combined rates exceeding 30% for high-income taxpayers. Losing the step-up in basis could result in substantial tax burdens for beneficiaries, especially for trusts holding highly appreciated assets like real estate or stock.
Moreover, clients who established irrevocable grantor trusts for Medi-Cal planning or asset protection may feel caught off guard. These trusts were often designed with the dual goals of asset preservation and tax efficiency, but Revenue Ruling 2023-2 undermines the latter by increasing potential tax liabilities for beneficiaries.
Solutions to Address Revenue Ruling 2023-2
While Revenue Ruling 2023-2 presents challenges, there are proactive strategies that could lessen the harsh result of losing the step-up in basis. Below are several potential solutions:
1. California Rules for Modifying Irrevocable Trusts
In California, modifying an irrevocable trust is governed by the California Probate Code, which provides two primary methods. First, under Probate Code Section 15403, a trust may be modified with court approval if all beneficiaries consent, provided the modification does not defeat a material purpose of the trust. This method requires a petition to the court, which will evaluate the proposed changes to ensure they align with the trust’s intent. Second, under Probate Code Section 15404(a), a trust may be modified without court approval if the grantor and all beneficiaries consent in writing, assuming the grantor is still alive and the modification does not violate the trust’s purpose. Both methods can be used to adjust trust terms to include assets in the grantor’s taxable estate, potentially securing a step-up in basis, but they require careful legal analysis to comply with state law.
2. Exercise of Power of Appointment
For clients with existing irrevocable grantor trusts, a thorough review of the trust’s terms is essential. In some cases, trusts may include provisions allowing the grantor or a trust protector to modify certain terms. For example, the grantor could retain a limited power of appointment or other powers that cause the trust assets to be included in their taxable estate, thereby qualifying for a step-up in basis. However, this must be balanced against estate tax implications and the original goals of the trust.
3. Swap Assets Using Substitution Powers
Many grantor trusts include a power of substitution, allowing the grantor to exchange trust assets with assets of equivalent value. Clients could use this power to swap low-basis assets (e.g., appreciated stock) held in the trust for high-basis assets (e.g., cash or recently acquired property) held personally. Upon the grantor’s death, the low-basis assets would be included in their taxable estate, qualifying for a step-up in basis, while the high-basis assets remain in the trust for beneficiaries.
4. Decanting the Trust
In California, trust decanting allows assets from one irrevocable trust to be transferred to a new trust with different terms, subject to state law and the original trust’s provisions. Decanting could be used to create a new trust that intentionally includes assets in the grantor’s taxable estate, securing a step-up in basis. Decanting requires careful compliance with California’s Uniform Trust Decanting Act and should be guided by experienced counsel.
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